This article initiates a discussion regarding Plural Rationality Theory, which began to be used as a tool for understanding risk 40 years ago in the field of social anthropology. This theory is now widely applied and can provide a powerful paradigm to understand group behaviors. The theory has only recently been utilized in business and finance, where it provides insights into perceptions of risk and the dynamics of firms and markets. Plural Rationality Theory highlights four competing views of risk with corresponding strategies applied in four distinct risk environments. We explain how these rival perspectives are evident on all levels, from roles within organizations to macro level economics. The theory is introduced and the concepts are applied with business terms and examples such as company strategy, where the theory has a particularly strong impact on risk management patterns. The principles are also shown to have been evident in the run up to—and the reactions after—the 2008 financial crisis. Traditional “risk management” is shown to align with only one of these four views of risk, and the consequences of that singular view are discussed. Additional changes needed to make risk management more comprehensive, widely acceptable, and successful are introduced.

Bust – Triage is the strategy best-suited resilience strategy for the bust.

Moderate – During the moderate phase steadily improving is the best strategy.

Uncertain – And the best strategy during uncertain times, as you have all figured out the hard way, is to diversify your business.

Many people and companies have been sticking with the Uncertain stage strategy – some for several years now. The political uncertainty has made that the sanest strategy. But when there is an actual default situation, we will all be faced with assuming that we will be continuing on with the drabness of the Uncertain stage or will we be popping into the Bust stage?

It makes a big difference to corporate and personal actions.

Under a continuation of the Uncertain phase, the best strategy is to continue with the small decisions to incrementally grow or shrink operations. Not making any big commitments or any big decisions. The firms that emerge successfully when the economy finally climbs out of Uncertainty are those who are already doing something that becomes a booming growth area. But only if they quickly recognize that the Uncertainty has ended and they shift into growth mode.

If the default creates a Bust environment, the companies who will be best off will be those who most quickly realize that and who immediately start to trim their less successful activities and associated expenses. These firms will deplete less of their resources defending a losing business and be better prepared to protect their core business through the Bust period. The ultimate winners will also need to recognize the end of the Bust and still have the resources to support the slow (or fast) growth that marks the end of the Bust.

This is where those scenarios come in handy. A company that has worked its way through the scenarios of the changes in environment will be better prepared to make these decisions about shifts in the environment.

If you are a risk manager, you have probably already worked through your nightmare scenario and have at least some ide of what you might do.

But if you are like the rest of us, you are probably just betting the they will work it out in the end.

Deep in our hearts, we would all choose a scenario with no surprises. Peter Wack, the father of scenario planning at Shell

My personal scenario is a muddle through. Just like in the situation of the Lehman default, where the decision was not to act until they saw the repercussions of the default ripple through global financial markets, the US Congress fails to reach a deal until some payments are delayed. The Treasury goes forward with the deferral process – paying bills in order of when they were due once they have the money. This goes on for a week or two and several of the NBC scenarios start to happen all at once. Then Congress finally acts and extends the debt ceiling.

They are still all wrapped up in their own world though and they only pass an extension that will work for several months. This turns out to be not enough to calm the markets and the chaos continues, even though the US is now paying its bills.

Ultimately, it results in the development of an alternate structure for the global reserve currency. This results in a permanent rise in the cost of funds for the US government. Which is itself catastrophic given the historically high debt levels and the long term government funding crisis.

But wait, discounting to the rescue. With interest rates higher, the future value of many long term obligations, especially at the state and local level suddenly shifts downwards. The funds that did the least to immunize themselves to interest rate shifts are saved by the power of compound interest as pension obligations magically shrink.

In the end, we – that is the developed countries that depend upon the modern financial system for our wealth – are all poorer by a third or more. And the US eventually votes one party or the other into a majority position and we try one of their solutions for a time.

But that drop in wealth is only recovered over a generation.

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RISKVIEWS sometimes remarks that ERM is the only management system that has been endorsed by the heads of state of the 20 largest economies (G20). The following is an excerpt from the G20 directive from the fall of 2008.

Risk Management

Immediate Actions by March 31, 2009

• Regulators should develop enhanced guidance to strengthen banks’ risk management practices, in line with international best practices, and should encourage financial firms to reexamine their internal controls and implement strengthened policies for sound risk management.

• Supervisors should ensure that financial firms develop processes that provide for timely and comprehensive measurement of risk concentrations and large counterparty risk positions across products and geographies.

• Firms should reassess their risk management models to guard against stress and report to supervisors on their efforts.

• The Basel Committee should study the need for and help develop firms’ new stress testing models, as appropriate.

• Financial institutions should have clear internal incentives to promote stability, and action needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking.

• Banks should exercise effective risk management and due diligence over structured products and securitization.

Looking at this list several years on and from outside of banking, we can ask if other financial institutions can get anything from these points. So we rephrase these points as questions (and provide preliminary answers for the insurance sector):

Are firms aware of risk management best practices? Most of the larger firms are aware. Quite a number of small to medium sized firms are not aware of best practices.

Are firms managing liquidity risk? Most insurers have provided for a very large range of liquidity needs.

Are firms managing concentration risks? Cat modeling provides information to most insurers about their property concentrations. Other concentrations may not be as well attended to.

Do firms assess their risk models? Insurers that had risk models before the crisis are much more wary of those models now. The insurance sector in the US has been slow in general to adopt a full company modeling approach. Insurers in Europe and in much of the rest of the world have adopted full company models for Solvency II compliance purposes. With the delay of Solvency II implementation, it remains to be seen whether those models will be used or shelved until required. Actions taken purely to satisfy regulation tend to be less effective.

Are firms using stress tests? Most firms are using stress tests. AM Best is urging all those who do not to develop the capability.

Do compensation programs incent decreasing or increasing stability? Most incentive programs do not reflect risk and therefore may incent increasing instability.

Do firms apply special diligence to more complicated risk structures? Most non-life insurers do not tend to participate in complicated risk structures. Many life insurers do manufacture and sell products with complicated embedded options and took large losses from those products in both 2001 and 2008 because they either did not try to hedge the risks (2001) or had hedging programs that did not perform as needed (2008). All who offer these products have made serious adjustments to their offering, their hedging or both, but it remains to be seen whether that situation will hold until the next financial crisis disrupts things in an unanticipated manner.

So five years later, the insurance sector seems to have acted on the six points made by the G20 in 2008. But there are many other elements to a fully effective ERM program. The ongoing theme of the G20 follow through on risk management through the Financial Stability Board is extremely bank centric. Insurers who rely upon this source of motivation for ERM will have the elements of ERM for their risks that line up with banks and little ERM for the insurance risks that predominate their operations.

In addition, banks and their supervisors do not seem to be even thinking about a true enterprise wide view of risk. Insurers that have taken up ERM are adamant about such a view being central to their ERM program.

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The 2013 ERM Symposium goes back to Chicago this year after a side trip to DC for 2012. This is the 11th year for the premier program for financial risk managers. April 23 and 24th.

This year’s program has been developed around the theme, ERM: A Critical Self-Reflection, which asks:

Has the risk profession become a spectator sport? One in which we believe we are being proactive, yet not necessarily in the right areas.

For the most significant headlines during the past year, how was the risk management function involved?

Since the financial crisis, has there been genuine learning and changes to how risk management functions operate?

What are the lessons that have been learned and how are they shaping risk management today? If not, why?

Does risk management have a seat at the table, at the correct table?

Are risk managers as empowered as they should be?

Is risk management asking the right questions?

Is risk management as involved in decision making and value creation as it should be, at inception of ideas and during follow through?

On Wednesday, April 24 Former FDIC Chairman Sheila Bair will be the featured luncheon speaker

Sheila C. Bair served as the 19th chairman of the Federal Deposit Insurance Corporation for a five-year term, from June 2006 through July 2011. Bair has an extensive background in banking and finance in a career that has taken her from Capitol Hill to academia to the highest levels of government. Before joining the FDIC in 2006, she was the dean’s professor of financial regulatory policy for the Isenberg School of Management at the University of Massachusetts-Amherst since 2002.

The ERM Symposium and seminars bring together ERM knowledge from the insurance, energy and financial sectors. Now in its 11th year, this premier global conference on ERM will offer: sessions featuring top risk management experts; seminars on hot ERM issues; ERM research from leading universities; exhibitors demonstrating their ERM services. This program has been developed jointly by the Casualty Actuarial Society (CAS), the Professional Risk management International Association (PRMIA) and the Society of Actuaries (SOA).

Riskviews will be a speaker at three sessions out of more than 20 offered:

Regulatory Reform: Responding to Complexity with Complexity – Andrew Haldane, executive director of Financial Stability at the Bank of England, recently made a speech at the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Policy Symposium titled “The Dog and the Frisbee” warning that the growing complexity of markets and banks cannot be controlled with increasingly complex regulations. In fact, by attempting to solve the problem of complexity with additional complexity created by increased regulation, we may be missing the mark—perhaps simpler metrics and human judgment may be superior. Furthermore, in attempting to solve a complex problem with additional complexity, we may not have clearly defined or understand the problem. How does ERM fit into the solutions arsenal? Are there avenues left unexplored? Is ERM adding or minimizing complexity?

We are drowning in data, but can’t hope to track all the necessary variables, nor understand all or even the most important linkages. Given the wealth of data available, important signals may be lost in the overall “noise.”

The importance of key variables changes throughout time and from situation to situation, so it’s not possible to predict in advance which ones will matter most in the next crisis.

We experience relatively few new crises that are mirror images of prior crises, so we really have limited history to learn how to prevent or to cure them.

Complex rules incent companies and individuals to “manage to the rules” and seek arbitrage, perhaps seeding the next crisis.

Actuarial Professional Risk Management – The new actuarial standards for Risk Evaluation and Risk Treatment bring new help and new issues to actuaries practicing in the ERM field. For new entrants, the standards are good guidelines for preparing comprehensive analyses and reports to management. For more experienced practitioners, the standards lay out expectations for a product worthy of the highly-qualified actuary. However, meeting the standards’ expectations is not easy. This session focuses on clarifying key aspects of the standards.

Enterprise Risk Management in Financial Intermediation – This session provides a framework for thinking about the rapidly evolving, some would say amorphous, subject of ERM, especially as applied at financial institutions and develops seven principles of ERM and considers their (mis)application in a variety of organizational settings. The takeaways are both foundational and practical.

The Maximizer will be sure that we can just Grow Out of It if the government will just get out of the way and let the market work its magic.

The Managers will believe that a careful process of gradual inflation will bring the economy back into line with the debt. This process will work if the expert government economists who really understand the problem are given their freedom to manage this. In the meantime, they will also want to increase the laws and regulations so that this sort of thing will not happen again.

The Conservators believe that since default is inevitable, then we might as well take our lumps and get it out of the way quickly. They will not be convinced, even after the default that anything has been completely solved and will continue to worry that there is more bad news just around the corner. So they will be preparing for the next shoe to drop. They will probably favor cutting spending to make sure that things come back into balance.

The Pragmatist will believe that there is not really a good way out and that the economy will be stuck in this stage of uncertainty for an extended period. They may even believe that the efforts of the others to try to solve the problems might extend that uncertain period even longer.

Looking back on the 1930’s we see that in various countries at various times during that decade that all four paths were tried by various governments.

What worked then? Well, you can find that there are four different opinions on what was the exact reason that we came out of the depression…..